Thursday, July 13, 2017

Hamilton's Blessed Debt

Hamilton’s Blessed Debt

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana University 

Delivered at Museum of American Finance, Wall Street, New York, 7/12/17 for MAF and AHA (Alexander Hamilton Awareness Society). Video will be available on C-SPAN details TBD.

            According to Duke University political scientist Richard Salsman in his new book, The Political Economy of Public Debt: Three Centuries of Theory and Evidence, people hold one of three views on government debt, if they hold any view at all. Holders of the optimistic view believe that debt is an unadulterated good, the closest thing to a free lunch possible in a world of scarcity. To fund their activities, optimists believe, governments need only sell bonds, preferably in their own currency. Or, if debt-issuance is too pricey, or too dicey, governments need only print money. Inflation will occur but inflation, especially unexpected inflation, is a good thing because it redistributes wealth from creditors, who are just evil rich people, to debtors, the poor salt of the earth.
            Holders of the pessimistic view, by contrast, think any government borrowing, especially long-term borrowing, an abomination. Borrowing simply imposes the tax burden on generations unborn. Every dollar the government borrows, moreover, takes a dollar away from entrepreneurs and businesses in a process called crowding out. Governments that borrow in another currency will soon find the burden too great and hard default, like Russia did back in the 1990s. Governments that are able to borrow in their own currency will soon print money to cover payments and soft default by causing unexpected inflation. That will hurt creditors, i.e., savers, the salt of the earth, and help debtors, a species of profligate swine.
            Holders of the third view Salsman calls realists. For them, context is everything. Borrowing is simply a tool that can be used responsibility to improve a nation’s economic situation or irresponsibly to destroy it. In some situations, government debt is good policy but in others it is unwarranted. So neither pessimists nor optimists are always wrong. It depends on the situation. Moreover, savers and debtors simply represent economic positions that can, and do, change over the life cycle. Neither group is inherently or morally good or bad.
            Alexander Hamilton’s view of the national debt can be summed up in a single quotation, a line from his April 1780 letter to a Philadelphia merchant and financier of the American Revolution named Robert Morris. The line is often given as quote a national debt DOT DOT DOT will be to us a national blessing unquote. That rendition, though, was designed by Hamilton’s enemies to paint him as a debt optimist in a country that was, due to its Mother’s long struggle with debt dependence, solidly pessimistic about sovereign debt. But the part left out of the quotation, the DOT DOT DOT part, shows that Hamilton was a debt realist and not prolix as it consisted of just five words, quote if it is not excessive unquote. So Hamilton believed that a national debt would be a blessing, if, and only if, it was kept within reasonable bounds, a concept to which we shall return in due time.
            But first, it is important to understand the context of the debt as Hamilton understood it. He was not advocating that the government should always borrow money to stimulate the economy or to transfer wealth to the poor in order to decrease the nation’s Gini coefficient or some other measure of wealth or income inequality. Rather, Hamilton was arguing for the eventual repayment of a debt already incurred by the state and federal governments to win the American Revolution. Some of the burden would fall on the unborn, as debt pessimists complained, but the unborn would receive something of immense value in return, their political liberty.
            To fail to repay the debt owed to foreigners, a position thankfully held only by a few xenophobes, would ruin the nation’s sacred honor and thereby prevent the United States from borrowing abroad to finance future wars or territorial expansions. Servicing the foreign debt would be costly in the short run but in the bigger picture would allow America to continue to borrow abroad should it need to.
More debt pessimists, however, were willing to repudiate the domestic debt, or the sums owed by the U.S. government to U.S. citizens. Such a move would simply be a one-time capital levy that would keep taxes down for everyone in the future, the debt pessimists argued. Most holders of government debt instruments or IOUs were speculators who had purchased them for pennies on the dollar. They were rich, in other words, and could well suffer the loss. In fact, the low price they were willing to pay for government IOUs proved that they expected a default.
Hamilton countered that the low prices reflected only the time value or opportunity cost of money, which was quite high in the 1780s, and the possibility, not the certainty, of repudiation. Again, context is critical as most of the IOUs were in default, with the issuing governments paying neither interest nor principal as promised, or resorting to the practice of paying interest on IOUs with yet more IOUs. Late in the 20th century financial historian Edwin Perkins showed that Hamilton was right and that early speculators in Revolutionary War debt did not earn windfall returns, especially when the risks they undertook are considered. In any event, Hamilton also argued that repudiation would be immoral and would make it difficult, if not impossible, for the federal government to borrow from Americans, and maybe even foreigners, when necessary in the future. That would mean the next war would have to be financed by oppressive taxes and/or the sale of state assets at ruinous prices.
To ensure that the federal government would not try to repudiate part of its debt by changing the value of money, Hamilton induced Congress to pass the Mint Act. In addition to providing for the production of U.S. coinage, the act carefully defined the U.S. dollar in terms of grains of silver and gold. That anchored the real value of all debts denominated in dollars and induced increasing numbers of Americans to give up reckoning value in their old colonial units of account, like York shillings, in favor a decimalized dollar.
Hamilton then went a step further and argued that the federal government ought to assume, or take responsibility for, the war-related debts of the several states. Boy did that ever make the debt pessimists howl! They feared that Hamilton was trying to create a huge, permanent national debt that would be used to cow the populace into submission to federal authority. But again Hamilton argued from first principles, noting that the states should not have been obliged to incur a wartime debt in the first place. Only the want of an effective federal government had necessitated the practice. Moreover, only the new federal government received the right to tax foreign trade so it could generate the revenue to repay the debts much more cheaply and easily than the state governments could do.
The debt pessimists, led by James Madison and Thomas Jefferson, also pushed for what was called discrimination. They proposed that the government repay the original holders of government wartime IOUs, who were mostly soldiers, sailors, and farmers, in combination with subsequent holders of the debt, who they depicted as wealthy speculators who defrauded the original holders. Hamilton put the kibosh on discrimination as well, noting the administrative difficulties of tracking the chain of ownership for each of hundreds of thousands of IOUs. Moreover, original holders had not been defrauded in most cases, they simply valued the cash payments they received over holding the IOUs until the bankrupt governments that issued them finally got around to repaying them. They knew when they sold that they were relinquishing all rights to the principal and were fine with it. To give them some of the cut would be a windfall for them but would ruin the nation’s reputation for fair dealing at both home and abroad.
With the aid of some astute backroom bargaining, Hamilton managed to implement most of his plan for the Revolutionary war debt, including assumption of state debts and non-discrimination against holders. Here is where most history books stop, though it is far from the whole story. The details of Hamilton’s funding program were brilliant and what ultimately established American public credit, or its ability to borrow again in the future, from sources foreign and domestic, to do nice little things like double the size of the country, fight and win a second war for Independence, defeat Mexicans angry over the annexation of Texas, and win a long, bloody War between the States that ended slavery, well kinda sorta. With the possible exception of Texas, those all sound like blessings to me. Just kidding: don’t mess with Texas.
As noted previously, markets for government IOUs existed throughout the 1780s but most were rather thin and hence inefficient, by which I mean costly and time-consuming. Literally scores of different types of IOUs were extant and not even brokers knew the details of each. Under Hamilton’s plan, holders of the IOUs traded them in for just three types of registered government bonds called Threes, Sixes, and Deferreds. Registered meant that the government tracked each owner of the bond by name and location, a fact that will help me make another point a little later.
Threes were so called because the government paid on them three percent interest annually, or zero point 75 percent quarterly to be precise. They were redeemable at the pleasure of the government, which meant, in effect, after the other bonds had been paid off because who in their right mind would pay a debt with only a three percent interest charge before it repaid higher interest debt?
The government paid six percent annually, or 1.5 percent quarterly, on Sixes, and retained the option to redeem up to 2 percent of the principal annually. That brilliant feature allowed the federal government to slowly repay the principal due on the bonds when it had adequate resources to do so.
Deferreds were so called because the government deferred paying interest on them until the end of the year 1800, when they converted in Sixes. They were zero coupon bonds, in other words, convertible on maturity not into cash but into Sixes. The market price of Deferreds slowly rose towards that of Sixes as maturity came ever closer.
When a holder of Revolutionary war debt redeemed their IOUs, most of which promised 6 percent interest, they voluntarily received a combination of Sixes, Deferreds, and Threes that yielded about 4 percent total. A few holders thought that a bad deal and held off but most preferred a more or less certain 4 percent over the possibility of one day receiving 6 percent. Hamilton’s bonds were fully funded, or backed by taxes and pledges, while the wartime IOUs were not. In addition, a liquid market for Hamilton’s bonds formed immediately. That means that holders could sell their bonds to other investors at fair market prices quickly and at minimal brokerage expense. Holders of Revolutionary War IOUs might not be able to find a buyer at all or they might be offered a lowball price. A holder of a Three, by contrast, could see the going rate published in the local newspaper and contract with a broker to sell it in a day or two for a half percent commission or less. Or, the holder could sell it immediately to a dealer for a dollar or so less than the price listed in the paper.
Debt pessimists complained that Hamilton’s debt would be perpetual because Threes were payable at pleasure and Sixes had no definitive repayment schedule. They were simply wrong about that as the national debt was entirely repaid during Andrew Jackson’s presidency. There was no way that Hamilton or anyone else could know that in the 1790s but clearly what Hamilton wanted was repayment flexibility. He wanted the government to repay its obligations when it was best able to do so, not according to some rigid schedule that might coincide with a war, a natural disaster, or an opportunity to buy additional territory.
The opportunity cost of the national debt, Hamilton argued, was low because his bonds did not lay idle, like so many full-bodied gold and silver coins did, in vaults and chests. Rather, federal bonds were often used to collateralize bank loans and to make large payments. Indeed, millions of dollars changed hands each year in thousands of separate transactions. Hamilton’s bonds were, in other words, near-money instruments that did not crowd out private investment to a considerable degree and that served a unique role in the portfolios of banks and other businesses as secondary reserves, or reserves that paid interest but could be quickly turned into cash when needed. After federal bonds had been extinguished in the 1830s, state bonds were demanded to fill those same roles but they never did so quite as well as Hamilton’s Threes, Sixes, and Deferreds had.
 The next line in Hamilton’s April 1780 letter to Robert Morris on the national debt explained that the debt quote will be powerfull cement of our union unquote. By that, Hamilton meant that one of the debt’s blessings would be political rather than economic. By making the federal government the creditor of people throughout the nation, the national debt would create political sentiments in favor of the Union as bondholders protected their vested interest in the health of the national government. Debt pessimists, including many historians with anti-Hamiltonian axes to grind, assumed and claimed that Hamilton’s bonds were owned only by a relatively small number of rich urban elites. I showed otherwise in One Nation Under Debt by using extant federal bond registers to show that tens of thousands of Americans throughout the Union owned federal bonds at some point.
I devoted an entire chapter to bondholders in Virginia, the home state of great debt pessimists like Thomas Jefferson. Many federal bondholders in Virginia owned plantations and slaves. Others were professional doctors and lawyers. Others were urban artisans and retailers. Some were women. Abigail Adams wasn’t the only female trading government securities, Woody! Some bondholders lived in what is now called NOVA, by what would become the nation’s capital. Others lived Southside, others on the Blue Ridge, others in the Valley, and others along the James, in Richmond and beyond.
We’ll never know with certainty what influence those bondholders had on public opinion in Virginia but the fact that federal bondholders were spread across the state both geographically and occupationally suggests that they well could have cemented the Union. One federal bondholder, Charles Dabney, was a bona fide Revolutionary War hero who had raised his own legion in defiance of the King’s tyranny. He owned a huge musket called Dabney and generally was considered what we would call today a badass. I doubt not that Dabney would have rode on Richmond, Dabney in hand, charged and primed, if the government there had threatened secession during his lifetime.
In addition to establishing public credit, keeping the Union intact, and providing investors with liquid, low-risk assets, Hamilton’s funding system kept total taxes to reasonable levels. State taxes all but disappeared for over a decade and federal taxes came mostly in the form of tariffs and tonnage duties, both of which were relatively cheaply collected and less distortionary than real estate taxes. Of course all taxes create some distortions. The infamous tax on whiskey that led to the Whiskey Rebellion was needed to offset the effects of the tariff on imported spirituous liquors, which were so high that they acted as a protective tariff. If it sounds odd to you that Alexander Hamilton counteracted a protective tariff that is probably because you have the wrong idea about Hamilton’s views on protection. Dick Sylla’s Illustrated Biography of Hamilton will set you straight on that.
I’d like to spend the rest of my time with you reviewing some of the salutary secondary effects of Hamilton’s Blessed Debt. Foremost among them was the Bank of the United States. Chartered in 1791, the Bank, or First Bank, Bus, or Be You Ess as it is sometimes called, was a commercial bank owned in part by private investors and in part by the federal government, at least until it sold its shares at an immense profit. The institution, which eventually established branches in eight seaport cities, primarily made short-term loans to businesses, including merchants and manufacturers, but it was also the federal government’s bank. It was responsible for paying interest on the national debt when it fell due four times a year, transferred money from where the government earned it, which was mostly in major port cities, to where the government spent it, which was mostly along the frontier and wherever bondholders lived, which was all over the place as I indicated a few minutes ago. Perhaps most importantly, the Be You Ess stood ready to lend the government money should it find that its debts due outstripped its current revenue.
The Bank of the United States also acted as a lender of last resort during the financial panics that hit the nascent financial system in 1791 and, harder and more infamously, in 1792. Under Hamilton’s guidance, it implemented what would later be called Bagehot’s Rule after Walter Bagehot, the founding editor of The Economist magazine who described the rule in his 1873 book Lombard Street: A Description of the Money Market in London. I’ve taken to calling the rule Hamilton’s nay Bagehot’s rule. Nay is spelled N E E and is a genealogical term that means originally called. Hamilton did not spell the rule out in a book but he implemented it perfectly, especially during the 1792 Panic when he persuaded bankers to lend freely at a penalty rate to all who could post sufficient collateral, i.e., his Threes, Sixes, and Deferred bonds, at rational prices. The markets soon steadied and the young American economy continued to grow robustly, an expansion that had begun soon after Hamilton announced his funding program.
The bubbles that burst in 1791 and 1792 included government bonds but also the stocks of the Be You Ess and the nation’s handful of other commercial banks, including the Bank of New York, which Hamilton had helped to found shortly after the British pulled out of Manhattan after the American Revolution. Before his untimely demise, Hamilton also helped to found two other corporations, another bank and the Society for the Establishment of Useful Manufacturers. All three had difficulties obtaining corporate charters at first, so Hamilton helped them to establish work arounds that had the effect of easing entry into the corporate sector, access to which state governments jealously guarded at first. Thanks to Hamilton’s loopholes, which established perpetual succession and even limited liability by contract, rather than statute, state governments realized that they had to ease charter requirements or face the formation of numerous unchartered, which is to say unregulated, joint-stock companies.
Due to the ease of entry forced by Hamilton’s legal genius, over 23,000 for-profit corporations received special acts of incorporation in the United States before its Civil War and another 10,000 plus chartered under general acts of incorporation. That was far more corporations per capita than any other nation on earth, including Britain, though it must be admitted that the Mother Country’s corporations were larger on average. Early U.S. corporations were engaged in transportation, including bridges, canals, roads, and railroads; finance, including commercial and savings banks, fire, marine, and life insurers, and building and loan societies; manufacturing, including everything from cotton and woolen textiles to steam engines; utilities, including water and gas light; and services, from cemeteries to hotels. Shares in all those endeavors traded in the same markets that had developed to exchange Hamilton’s bonds and eventually many businesses, and state governments, learned from the federal government and began selling bonds to finance their operations as well.
What Hamilton’s funding plan amounted to was nothing short of a financial revolution. In just 5 years, America went from being backwards and bankrupt, without public credit or even a clear unit of account in which to denominate debts, to a nation with a well-defined dollar, taxes sufficient to pay the interest on a large debt composed of liquid bonds owned throughout the nation and abroad, and small but growing commercial banking and insurance systems.
Hamilton’s financial revolution, in turn, made possible the agricultural revolution described by Winifred Rothenburg, Paul Rhode, and others, whereby farm efficiency increased as crop yields jumped and a local transportation revolution -- bridges, short canals, and turnpikes -- made it less expensive to bring goods to market. The agricultural revolution freed laborers from farm work, making them available to work on regional transportation connections like long canals, railroads, and steamship lines. Improved transportation meant a much lower cost per ton mile, which rendered feasible the growth of both cities and factories in the nation’s vast interior. Thanks to the series of economic transformations initiated by Hamilton’s financial revolution, the North, and even parts of the South, industrialized before the Civil War. If you didn’t know that already, it is because Alfred Chandler and other early business historians didn’t have very good archival skills and simply assumed the antebellum economy away.
Since passage of the U.S. Constitution, white male citizens enjoyed a government that protected life, liberty, and property from invaders foreign and domestic. The bonds that composed its national debt traded regularly in public markets, so there was constant affirmation of the government’s willingness and ability to fulfill its promises. The new government created by the Constitution was key. While places like Western New York experienced agricultural, transportation, and industrial revolutions and thrived economically, adjacent areas in Upper Canada with identical culture, climate, flora, and fauna remained economically backward. Canada, after all, was still subject to the whims of a distant monarch and his or her placemen in the New World but de facto ruled by unelected oligarchic cliques bent on rent-seeking.
Only after Canadians won their independence from the cliques in the 1830s and 1840s and from the Crown in 1867 did Canada begin to catch up to America economically. By the time I began making beer runs to Ontario in the late 1980s, Western New York and Canada were virtually indistinguishable, except for the drinking age and the metric system. Virtual economic parity, I’m told, had been reached several decades earlier. Now, if anything, the Toronto half of Torafalo, or Buffaronto if you will, that urban stretch that runs from the eastern shore of Lake Erie, down both banks of the Niagara River to the Falls, and then along the western part of Lake Ontario, looks rather nicer than the Buffalo half.
The reason for the present disparity may well be that the U.S. national debt has become excessive. It is now larger than the nation’s annual GDP and seemingly out of control while Canada’s national debt is just 66 percent of its GDP and under control. While the nominal national debt stayed about the same during Hamilton’s tenure as Treasury Secretary, strong economic and population growth meant that debt as a percentage of GDP dropped dramatically. Thereafter, thanks to the fiscal constitution -- a series of rules about borrowing and taxation like don’t borrow without dedicating a tax to service and repay the debt --  that Hamilton put into place, the national debt increased as a percentage of GDP only during wars and depressions and after territorial acquisitions, like the Louisiana Purchase. After each of those borrowing binges, economic growth and small budget surpluses combined to reverse the trend.
            As recently as the end of the Cold War in the early 1990s, the U.S. debt to GDP ratio improved, so much so that at the end of Bill Clinton’s second term there was genuine concern that U.S. government bonds would become completely extinct for the second time in U.S. history. But it was not to be, as debt optimists swept into power and destroyed Hamilton’s fiscal constitution under the cover of putative wars on terror and drugs. In fact, all Bush II and Obama have done is to borrow and spend in order to win votes. Taxing and spending is too risky as people immediately feel taxes. Most, however, pay little attention to borrowing and the debt optimists are there telling them that they needn’t worry about the national debt as everything is going to be just fine, which is true only for those who owe more than they own and aren’t reliant on bonds, Social Security, or other forms of fixed income.
            And I’m just talking about the explicit part of the national debt. So-called entitlement programs add many trillions more to the nation’s fiscal burden. Interest on the national debt in 2016 amounted to $241 billion, or 1.3% of GDP. Spending on Social Security, Medicare, and Medicaid totaled $2 trillion, or a little over 10% of GDP. We’ll spend even more in 2017 but the spending is formulaic and hence largely capped. Interest paid on the national debt, by contrast, could skyrocket because most of the debt comes due and must be refinanced every five years or so. Interest rates are low now but heading higher and effectively are not capped. They reached into the upper teens in the late 1970s and could go there again if inflation expectations rise. By 2023 we could be spending 20% of GDP on debt service, which would put tremendous pressure on other areas of expenditure, including Defense, which is currently 3.2% of GDP, and nondefense discretionary spending, which is currently 3.3% of GDP. And that, of course, would put tremendous upward pressure on tax rates and would force places like Buffalo to wallow in idleness, its enterpreneurs crowded out of funding by the massive borrowings of the federal government. Twenty percent is a nightmare scenario but sometimes nightmares come true, as they did multiple times when I was growing up in the 1970s. So please forgive my Hamiltonian realism.
            Is there anything we can do to get out of this fiscal mess? Yes, thanks for asking. Hamilton advised the creation of an energetic, efficient government, one that did one thing well for as little money as possible. That one thing was to protect American’s lives, liberty, and property from tyrants foreign and domestic. Straight off, I think that Hamilton would slash the military’s budget without degrading its ability to deter foreign incursions. Nuclear weapons can deter foreign states, at least rational ones. Terrorists are best interdicted at the borders and place of attack, not the mountains and deserts of Asia.
Much of the rest of what the federal government does is to subsidize one group at the expense of another and hence not only can it be scaled back, it should be scaled back, slowly so that people can adjust. Phasing out the Department of Education, for example, would not end all education in the United States, it would merely force parents to fund their children’s educations, which most could do if their tax bills were not so high.
The so-called entitlement programs Hamilton would phase out over time and in the process render the poor better off. Yes, you heard that right. A study by the National Bureau of Economic Research, for example, showed that Social Security redistributes wealth from poor black men and Hispanics to white middle class widows. Moreover, Social Security’s life annuity works to increase wealth disparities by ensuring that the poor own no assets to pass to their children or grandchildren. Phasing out Social Security would not relegate the nation’s elderly to eating pet food, it would give people incentives to save for retirement, just as they did before Social Security was implemented in the 1930s in response to a temporary macroeconomic problem.
            Hamilton would also stop the war on drugs, which is really just a war on brown people, against whom he held no discernible prejudice. He would work to improve the administration of justice for African-Americans, Hispanics, American Indians, and immigrants so that they have incentives to work harder and smarter. That mostly means to stop doing expensive things to people and simply allow them to live like other Americans, without fear of the police, ICE, and so forth. If you don’t believe me, you should have come to my talk at Fraunces Tavern on Monday night, where I explained that Hamilton thought blacks equal to whites in every way and advocated freeing the slaves. As for Hamilton’s views on Indians, look into the history of Hamilton College.
            But the most important thing Hamilton would do today is to restore America’s fiscal constitution, a flexible set of rules established by debt realists for debt realists. As brilliantly described by Bill White, a Democratic politician and businessman from Texas, America’s fiscal constitution held that the federal government should borrow only when absolutely necessary, as during declared wars or to finance a territorial acquisition, and only when a tax sufficient to offset the borrowing was passed and dedicated to the debt’s repayment. That way, the ability of the government to repay the debt is demonstrated and, more importantly, the future cost of the borrowing is laid bare. Bush II and Obama, Whites showed in his 2014 book, America’s Fiscal Constitution, replaced those commonsense checks and balances with nonsense about the debt ceiling.
The first step is to run the debt optimists out of power, and replace them with debt realists, like Hamilton, so they can restore our fiscal constitution. Then we need to let the economy grow into the debt, shrinking its burden in the process. That does not mean austerity or even running surpluses, it just means keeping federal government deficits small compared to productivity advances. If America can stay out of war, real and fanciful ones, for a decade or so, the national debt will become non-excessive once again, and places like Buffalo will prosper once more. If America can learn to treat all its citizens equally, and slowly phase out parts of the federal government it never really needed in the first place, the national debt will again become a blessing, and places like Buffalo will blossom as never before.

Thank you!

1 comment:

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